September 2020 (1) An Oil marketing firm in India COI Ltd is currently only in the downstream business and hence has to procure the crude oil from elsewhere. They plan to enter the upstream business so as to integrate vertically in the value chain. The project that you have identified is in Papua New Guinea (PNG). The ministry in PNG has invited bids for an on-shore reserve in PNG which will give you access to the reserve for 10 years. You are now thinking of arriving at the best bid price for this project, which is an upfront payment that is not amortized. The expected annual sales revenue of the crude oil sales to your refineries (using transfer pricing method) is provided to you in the Table 1 below. Projections factor in potential reduction in oil prices given the rapid shift to clean energy. Total costs of production is 40% of the revenues. The machinery for the rigs would cost you 1600 million. As the machinery is specific to the geography, you are going to depreciate it on an accelerated basis of 25%. You expect this machine to be sold for 10 million at the end of the 10 year period. As it is a new product, the firm expects an initial investment of *25 million in net working capital. Subsequently, depending on revenues, the net working capital at year end would be 10% of the next year revenues. The firm expects to recover all the working capital by the end of the project's life. COI had sent a contingent to evaluate the terrain and the promise of the oil reserves last year incurring a cost of 5 million. The report was favorable for investment. The effective tax rate at OCI is 20%. As the company is venturing into a non-core business, they are contemplating the right discount rate. The firm management has estimated the asset beta of the COI Ltd to be 1.2. The market risk premium is 8% and the risk free rate is 6%. In addition, the management is privy to the asset betas of upstream companies who are new in this business to be in the range of 1.6 to 1.8. Compute the NPV of this project assuming that COI plans to use all equity financing and compute the amount that can be bid for access to this site if the minimum NPV determined by management is 50 million after all costs are factored in. Historically, the average bids for such sites in PNG was in the region of *650 million. Now, you are contemplating to increase value of this project by going for partial debt financing. The creditors are reluctant to grant the loan for 10 years and hence have offered 200 million for a 5 year period with a condition to repay the principal in equal installments at the end of each year for the next 5 years. Cost of debt is 8%. What is the incremental value of debt financing. What is the NPV of the project now? The management is still looking for additional value. The ministry in PNG, given the strategic interests of the bilateral relations offers you a subsidized debt with the same terms as the creditors except for the price, which is lowered to 4%, lower than the risk free rate. In addition, you have managed to convince the tax authorities that the machines can be depreciated fully in the first year. What is the incremental value of each of these measures. What is the NPV of the project now? 1 2 3 4 5 6 7 8 9 10 Sales revenue (in millions) 500 550 600 700 750 750 600 500 400 400 Table 1: Projected Sales September 2020 (1) An Oil marketing firm in India COI Ltd is currently only in the downstream business and hence has to procure the crude oil from elsewhere. They plan to enter the upstream business so as to integrate vertically in the value chain. The project that you have identified is in Papua New Guinea (PNG). The ministry in PNG has invited bids for an on-shore reserve in PNG which will give you access to the reserve for 10 years. You are now thinking of arriving at the best bid price for this project, which is an upfront payment that is not amortized. The expected annual sales revenue of the crude oil sales to your refineries (using transfer pricing method) is provided to you in the Table 1 below. Projections factor in potential reduction in oil prices given the rapid shift to clean energy. Total costs of production is 40% of the revenues. The machinery for the rigs would cost you 1600 million. As the machinery is specific to the geography, you are going to depreciate it on an accelerated basis of 25%. You expect this machine to be sold for 10 million at the end of the 10 year period. As it is a new product, the firm expects an initial investment of *25 million in net working capital. Subsequently, depending on revenues, the net working capital at year end would be 10% of the next year revenues. The firm expects to recover all the working capital by the end of the project's life. COI had sent a contingent to evaluate the terrain and the promise of the oil reserves last year incurring a cost of 5 million. The report was favorable for investment. The effective tax rate at OCI is 20%. As the company is venturing into a non-core business, they are contemplating the right discount rate. The firm management has estimated the asset beta of the COI Ltd to be 1.2. The market risk premium is 8% and the risk free rate is 6%. In addition, the management is privy to the asset betas of upstream companies who are new in this business to be in the range of 1.6 to 1.8. Compute the NPV of this project assuming that COI plans to use all equity financing and compute the amount that can be bid for access to this site if the minimum NPV determined by management is 50 million after all costs are factored in. Historically, the average bids for such sites in PNG was in the region of *650 million. Now, you are contemplating to increase value of this project by going for partial debt financing. The creditors are reluctant to grant the loan for 10 years and hence have offered 200 million for a 5 year period with a condition to repay the principal in equal installments at the end of each year for the next 5 years. Cost of debt is 8%. What is the incremental value of debt financing. What is the NPV of the project now? The management is still looking for additional value. The ministry in PNG, given the strategic interests of the bilateral relations offers you a subsidized debt with the same terms as the creditors except for the price, which is lowered to 4%, lower than the risk free rate. In addition, you have managed to convince the tax authorities that the machines can be depreciated fully in the first year. What is the incremental value of each of these measures. What is the NPV of the project now? 1 2 3 4 5 6 7 8 9 10 Sales revenue (in millions) 500 550 600 700 750 750 600 500 400 400 Table 1: Projected Sales